Arthur Young

1. Arthur Young was criticized for not encouraging Lincoln to invoke the substance-over-form principle when accounting for its large real estate transactions. Briefly describe the substance over form concept and exactly what it requires. What responsibility, if any, do auditors have when a client violates this principle?

Substance-over-form is an accounting principle used to ensure that financial statements give a complete, relevant, and accurate picture of transactions and events. If an entity practices substance-over-form, then the financial statements will show the overall financial reality of the entity. This concept becomes even more relevant when transactions may not be made at arms-length, often involving related parties. This was the case with Lincoln Savings and Loan complex real estate transactions. Arthur Young should not have accepted the questionable documentary evidence provided by Lincoln employees to corroborate the savings and loan’s real estate transactions. Auditors have a responsibility when a client violates the substance-over- principle. The auditor should be examining and testing client transactions to ensure this principle is not being violated. If a discrepancy is discovered, it needs to be considered in terms of the overall effect on the client’s financial statements. If the misstatement is material, it must be corrected or the auditor needs to issue a qualified or adverse opinion.

2. Explain how the acceptance of large, high-risk audit clients for relatively high audit fees may threaten an audit firm’s de facto and perceived independence. Under what circumstances such prospective clients should be avoided? When an auditing firm’s clients are large, high-risk clients for relatively high audit fees, there is a risk that independence will be compromised if it has the potential to end the relationship with a profitable high-risk client. Add to this, the client having a high audit risk, and it has the potential to make the audit process more difficult and problematic. The auditing firm may also be considered to be more flexible and less independent than other firms. Prospective clients should be avoided if the auditing firm is aware of fraudulent or unethical behavior, pending litigation or public violations, history of auditor confrontations. Auditing firms should not accept any client that might threaten the firm’s de facto and perceived independence. Sacrificing an audit fee is a small price to pay to retain the firm’s reputation.

3. How is an auditors’ examination affected when a client has engaged in significant related party transactions? What measures should an auditor take to determine that such transactions have been properly recorded by a client? An auditor’s examination is greatly affected when a client has engaged in significant related party transactions. The audit risk is immediately much higher. The auditor must ensure that the substance-over-form principle is clearly in practice and that all transactions are fully disclosed. The auditor also needs to ensure that the nature of the transactions is clearly explained in the footnotes and are in compliance with GAAP. Measures an auditor should take to determine that such transactions have been properly records by a client are as follows: Ensure the Board of Director’s approved the transaction, examine the paperwork and ensure it reconciles correctly, consult with other parties outside the client’s firm who were involved in the transactions (attorneys, guarantors, banks), engage a specialist should the need occur to ensure that the recorded amounts of the related party transactions are within normal limits and are reasonable.

8. Does the AICPA Code of Professional Conduct discuss the collegial responsibilities of CPA firms? In your opinion, were representatives of either Ernst & Young or Kenneth Leventhal & Company unprofessional in this regard during their Congressional testimony? The AICPA Code of Conduct does not specifically discuss the rules regarding collegial responsibilities of CPA firms. However, a level of professional behavior, designed to ensure the auditor’s independence is implied. In my opinion, the representatives of either Ernst & Young or Kenneth Leventhal & Company were unprofessional in regard to their congressional testimony. Not producing subpoenaed documents in a timely fashion and providing copies that were illegible or obscured is highly unprofessional. As an auditor, one should err on the side of conservatism and ensure that a grey area is disclosed to the proper compliance authorities.

9. What responsibility does an auditor have to uncover fraud perpetrated by client management? Discuss factors that mitigate this responsibility and actors that compound it. Relate this discussion to Arthur Young’s audits of Lincoln. AU section 110 requires the auditor to “obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.” The fraud triangle is composed of three key components, pressures, opportunity, and rationalization. In the case of Arthur Young’s audits of Lincoln, there were many opportunities for auditor to identify and uncover the fraud. Arthur Young should not have accepted the questionable documentary evidence provided by Lincoln employees to corroborate the savings and loan’s real estate transactions. Arthur Young also did not hire outside appraisers to evaluate the real estate values, instead opting to use Lincoln’s appraisals.

The pressure to gain new clients also added to accepting Lincoln as an audit client by Arthur Young. Shortly after accepting the Lincoln audit, Arthur Young found out Lincoln was being audited by the FHLBB. Arthur Young should have withdrawn from the audit the minute they found out about the serious allegations resulting from the FHLBB audit. Another mitigating component to the Lincoln debacle is the close relationship between Arthur Young’s management and Lincoln’s management. Jack Atchison was an audit partner who later went to work for Charles Keating. This close relationship hurt Arthur Young’s independence. When top management is involved in fraud, it is usually very hard to detect. However, given the migrating factors, Arthur Young should have uncovered this fraud.